Thursday, March 25, 2010

The Most Dangerous Call You Will Hear Today

Today we here at NotMakingThisUp break with a longstanding tradition of identifying “The Least Helpful Call You Will Hear Today” in order to identify a new category of Wall Street research.

We call it “The Most Dangerous Call You Will Hear Today,” and until today it has not existed for the simple reason that before the financial crisis came along and caused all manner of failing CEOs—from the lowest, least-material money-losing internet company to the whitest white-shoe Wall Street firm—to blame their own material failures on unnamed, unknown, and never-identified “short-sellers,” it seemed impossible to fathom that any thoughtful research opinion could be construed as dangerous.

Indeed, 30 years ago, when we started on Wall Street as a very junior number-cruncher in the equity research department of a large and proud Wall Street firm, our boss—a forceful, smart, hard-driving Greek—published whatever he wanted to publish, whenever he wanted to publish it.

Investment bankers and CEOs be damned.

Your editor can still picture the man waving his cigarette in the air—smoking was allowed in office buildings back then—when somebody from above tried to interfere with us, and using to remarkable effect the kind of language Lehman CEO Dick used when his firm was collapsing under the pile of bad real estate loans and bad LBO loans Fuld’s team had assembled, as depicted by Andrew Ross Sorkin in his excellent book, “Too Big to Fail.”

But those days are long gone.

As commercial banks bought up investment banks, old-style research became a tool for the bankers to win new clients and pacify existing ones. Worse, even Moody’s and S&P—so-called independent ratings agencies—saw the writing on the wall, and wrote pretty much whatever their clients asked them to write.Worse still, independent research firms started getting sued merely for publishing negative research.(Next thing you know, short-sellers will be sued simply for being short-sell—oh, wait, that’s already happened….)

In light of this perverse turn of events, today’s research call from something called “WBB Securities” looks even more remarkable than it might otherwise appear.

For WBB Securities has, we are informed, slapped not merely a “Sell” rating on a stock—shocking as that would be—but a “Sell Short” rating, at least according to the indispensible Briefing.com:

WBB Securities downgrades MELA to Sell Short from Sell and lowers their tgt to $5 from $7.25 saying while they find MELA's candid assessment of the difficulties assailing the FDA and companies before the agency refreshing, they also find it cause for concern in assessing the chances and delays in approval of a PMA product when, according to management, this is "not what's supposed to happen" in the approval process. Firm says as a result of this FDA response and a re-assessment of their modeling of MELA, they are lowering their rating.

Now, Electro Optical is not your garden-variety money-losing investment bank or internet retailer. Electro Optical has developed a gizmo that illuminates potential melanomas on the skin: hence the company’s stock ticker is “MELA.”And melanoma is bad—very bad. Most people have no idea how bad a malignant melanoma can be. (How otherwise to explain the current younger generation’s infatuation with a new brand of cigarette known as The Tanning Salon?) Electro Optical’s gizmo is a bit like an ultra-sound device that uses light waves to detect “suspicious pigmented skin lesions” for possible biopsy. It’s a great idea, replacing as it would the inefficient method by which a harried, time-short doctor merely looks over the skin.

The market potential for such a product could be enormous, but for reasons we here at NotMakingThisUp don’t grasp—and to be clear, we have absolutely no interest in the stock as a long or a short—the company has encountered a bumpy road to FDA approval, as yesterday’s news demonstrates.

Whatever the problem with the gizmo itself, the company, according to our Bloomberg, has a debt-free balance sheet and close to $30 million in cash. Unfortunately it’s lost roughly $18 million in each of the last two years while pursuing regulatory approval.

That's what an analyst-friend of ours used to call “a spicy meatball.”

And while slapping a “Sell” rating on any stock is difficult enough these days—courting as it does the wrath of investment bankers and CEOs—putting a “Short-Sell” rating on anything short of an already-bankrupt company in a world in which short-sellers have been blamed for the failings of the men who ran Lehman, Bear Stearns, Fannie Mae, Freddie Mac, Countrywide Credit, AIG, GE, Merrill Lynch and Wachovia, not to mention the entire country of Greece, is almost inconceivable.

Which is why we nominate the WBB rating on MELA The Most Dangerous Call You Will Hear Today.

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

12 comments:

I nominate the practice of putting cute phrases like *the most dangerous call you will hear today* in initial CAPS to inflate one's self importance as The Most Annoyingly Lazy Blog Habit You Will Find Today.

Why didn't Buffet, who prides himself on picking honest management, and only investing into sensible businesses that he could understand, within his circle of competence, buy 20% of Moody's, a company that was so obviously the cause of so much of the devastation he warned about. Could he not see that their AAA ratings of toxic subprime was a sham. And why not blow the whistle before they triggered worldwide disaster?

Steve asked why we label tanning salons as a 'new brand of cigarette,' and says he 'gots to get my vitamin d somehow.'

Steve, who doesn't capitalize his sentences because apparently that isn't necessary anymore, can get his Vitamin D by eating foods full of Vitamin D, such as fish; or by taking a vitamin pill; or, as he says, going to a tanning salon.

But only one of those three methods exposes Steve to the risk of joining one of the few growth markets in cancers left in the US, and one of the deadliest.

And if Steve thinks the risk of getting malignant melanoma is worth the cool tan he gets--a tan that immediately labels him "guy who goes to tanning salon to look cool" for all to see--he can just Google it.

I neither own a tanning salon, nor have ever used one, but this idea that tanning causes melanoma is wrong. You should google it yourself, and you would see that tanning causes skin cancer, but not melanoma skin cancer. In fact, while farmers and fishermen and other people who spend enormous amounts of time in the sun get more basal cell skin cancer, and more squamous cell skin cancer, they get LESS (sorry about the capitals) melanoma.

You may still scorn the vain pursuit of a tan at the cost of potentially defiguring skin aging and non-fatal skin cancer, but melanoma doesn't belong in the list of reasons for avoiding it.

The title of your post prompts me to ask a rhetorical question: for whom is the call "most dangerous" - MELA, the company which is the subject of analysis, or the individual investor who blindly accepts WBB's analysis at face value and fails to skeptically consider a set of counterfactual arguments to WBB's opinion of MELA?

No need to answer my question, obviously.

If I were a sell-side equity analyst, however, forming an investment opinion of MELA, here are some questions I would ask:

A) What is MELA's historical cash burn rate and how does their cash burn rate compare to the cash burn rate of similar companies at MELA's stage of development?

B) What is the short interest in MELA and how does this compare to MELA's 1, 3 and 6 month average?

C) Does the price of MELA reflect all of its risk factors (i.e., material events that would potentially cause a further loss) and if so, what is the probability that those risk factors, should they come to pass, cause a further decline in MELA's share price, which would validate WBB's short sell opinion?

No need to answer those questions, either.

In the interest of full disclosure, I do not hold an investment position (long/short) in MELA, and I do not work for the company.

You missed one other possible party for whom this might be the most dangerous call: the analyst who wrote the report.

This has to be one of the most subtle nuances Jeff has put into one of his posts. My guess is that Jeff knew all along the ambiguity of his title--or at least the ambiguity implied from identifying to whom the danger of this call applies.

Full disclosure: I never heard of MELA until I read this post. I do not own and have never used a tanning salon. I take 2000 IU of Vitamin D3 every day during the winter.